As US fiscal cliff looms, the markets will be jittery

The cliche goes that if the US sneezes, the global markets get the flu. But what happens if the US markets catch the flu? That possibility looms on the horizon as fiscal cliff negotiations go down to the wire.

The fiscal cliff is a term for the deep spending cuts of $110 billion per year and sharp tax hikes slated to hit the US economy in 2013, unless President Barack Obama and the US Congress find a solution. The combination of spending cuts and tax hikes is expected to tip the US economy back into a recession. And so far the politicians have not been able to reach a solution. Hence next week is crucial.

AP

The President and opposing Republican leaders met again on Friday but could not reach a deal. The President has now asked the opposing Senate leaders, Democrat Harry Reid and Republican Mitch McConnell, to find a compromise solution that can pass the Senate and the House.

In a press conference the President said he is optimistic that a solution can still be reached. The House of Representatives has been called into session on Sunday to vote on a solution. So by the time the market opens on Monday, we'd all know what's in store next week and probably into early next year. After repeated failure of the Democrats and Republicans to reach a solution, the market does not expect big agreement to resolve the fiscal cliff. There could be a small agreement on taxes and spending to avoid a doom and gloom situation.

So how will the stock markets react? The US markets are already discounting a negative outcome. A look at the Dow Futures chart shows the index lower on fiscal cliff concerns (click here for the Dow Futures chart). Nifty, on the other hand, is still hovering at resistance. (click here for the Nifty chart). A good outcome on the fiscal cliff issue can result in the Dow rallying strongly and the Nifty breaking out of resistance. A bad outcome could lead to a fall in the Nifty and further bearishness for the Dow.

The fiscal cliff is the confluence of the expiration of the Bush era tax cuts and sequestration. Not only will income taxes go up for everyone with the expiration of the tax cuts, but also the dividend and capital gains taxes. Sequestration will result in massive federal spending cuts. Higher taxes on stock market income is expected to push equities lower. But with an increase in income taxes there will be less take-home pay for everyone. This comes over and above the new taxes that kick in under the Healthcare Law passed by the Democrats in 2010. Since the US economy depends on consumer spending, less take-home pay will have a devastating effect. Couple that with a cut in federal government spending, and we could see a strong contraction in the US economy.

Since the US economy is a primary driver of the global economy, we could see the world markets slow down if the US goes over the fiscal cliff. There are serious differences between the two political parties on how to deal with the fiscal cliff. On the tax side, Democrats want the Bush tax cuts to expire on anyone making more than $250,000. Republicans don't want to increase the tax rates on anyone and want to raise revenue by reducing tax exemptions and making the tax code simpler. Some Republicans were willing to allow the tax cuts to expire on people making more than $ 1 million, but could not get the rank and file party members to vote in favour.

On the spending side, there has not been as much discussion as on the tax side. However, broadly speaking Democrats want no cuts in discretionary spending or entitlements like social security and medicare. Republicans, on the other hand, don't want cuts in defence spending. On both these issues the opposing parties seem very far apart. One thing to note is that when US politicians talk of a spending cut, it is not really a cut, but a reduction in the growth of spending. Under US rules of base lining, the size of the budget increases automatically by about 6 percent. So under the new proposals to cut spending the growth will be lower.

As we go to press, the President has asked opposing leaders of the Senate to reach a deal. By taking himself out of the discussion the President that left the whole solution leaderless. The two sides have been bitterly opposed to each other on the fiscal cliff issue for a long time and it's usually the President that tries to get the them together. By washing his hand off, it looks like Obama does not want any blame for a failure in avoiding the cliff.

According to reports, the Democrats would try to delay the $110 billion in spending cuts that take effect next year. On the tax side it seems that Democrats would agree to allow the Bush tax cuts to stay for incomes of up to $400,000, up from the previously proposed $250,000.

First, it remains to be seen if leaders of both parties can agree to a deal. Most importantly it remains to be seen if the proposal pass the two chambers of congress. The Republican-controlled house has already rejected the proposal to increase taxes on people earning over $1 million, so it look unlikely that they will agree to a much lower threshold of $400,000. But if a bipartisan group of Democrats and Republicans vote in favour the doom and gloom of the fiscal cliff might be averted.

Keep in mind that any solution will be a short-term fix and big problems of debt, spending, social security and medicare are still in play. These concerns will provide bearish headwinds to the market.